Swings and roundabouts
The long-term success of the marketplace lending model in the UK will depend on how enduring its competitive advantages are, and how well marketplace lenders (MPLs) mitigate risks. In this blog, we explore some of the principal sources of competitive advantages for MPLs in the UK, and also some of the strongest headwinds facing them.
Competitive advantages of MPLs in the UK:
MPLs offer a superior customer experience in the following ways:
- slick and swift application and underwriting process, with few documents required
- fast lending decisions
- flexible lending metrics across the board, but particularly for SMEs
- transparency of what lender funds are being used for e.g. the ability to specify the risk you take on and to see loan books.
These advantages largely arise from platforms' focus on user experience (UX) as a source of differentiation from the outset. This is a more holistic approach than just digitally refurbishing a version of today.
Broad risk appetite
MPLs' brokerage-like structure, wider risk appetite and the diversification achieved by the ability to pool money invested and lend out to several borrowers lead to:
- wide coverage of businesses or individuals eligible for loans, i.e. high acceptance rate
- matching high-risk borrowers with yield-seeking investors and low-risk borrowers with risk-averse investors
- ability to respond to market ups and downs in credit markets.
MPLs operate on "lean start-up" principles enabling fast innovation, which include:
- inclination to use alternative data sources in some segments e.g. SMEs, customers with limited credit history
- frequent credit-scoring algorithmic iteration
- meeting a market demand for flexibility in repayment terms.
These qualities arise from a number of factors:
- light-touch regulation
- lack of legacy IT systems, requiring and enabling fintechs to build end-to-end processes from scratch.
Low-cost operating model
In simple terms not being a bank allows MPLs to benefit from:
- low operating costs (opex)
- little excess capital or liquidity buffer required in the system (impairment costs, i.e. the costs of providing for possible defaults).
These qualities arise from a lack of legacy IT systems, not having to maintain a branch network, and not being subject to the UK bank levy (as they are not banks).
Headwinds facing MPLs in the UK:
Cost of funds
Our indicative analysis of the costs of loans for banks and MPLs show that the funding costs for a bank loan are likely to be lower than the equivalent costs for an MPL loan. As funding costs account for a greater proportion of the costs of an MPL loan than those of a bank loan, MPLs are more sensitive to an increase in interest rates.
It is, therefore, important for MPLs to keep their funding costs as low as possible. But will MPLs be able to attract enough investors, at a low enough yield, to reach an economic scale? Creating sufficient liquidity is also a challenge, particularly on the funding side.
The MPL model is high-volume low-margin, therefore turning a profit in this business requires scale. Platforms need to attract a large number of borrowers to be viable. However, our consumer and SME surveysi demonstrate that:
- while marketplace lenders enjoy a high level of awareness, they struggle to convert awareness into usage
- unfamiliarity, security concerns, distrust and no prior relationship are the key deterrents for individual and SME borrowers.
MPLs' current strategy of targeting niche markets may also make it difficult for MPLs to expand their customer reach.
Many investors on the platforms may arguably be either ill-informed or ill-equipped to understand the true risk that they are taking on. For example:
- despite MPLs making it clear on their websites, there is a risk some investors may be unaware that their investments are not covered by the Financial Services Compensation Scheme (FSCS)
- investors may view provision funds as a guarantee of their investment, rather than a mitigant
- some investors may fail to recognise that there is a limited or non-existent secondary market for loans originated via MPLs.
The credit risk scores that MPLs assign to borrowers are based on the perceived default risk on issued loans. Mispricing the risk would lead to higher levels of default than predicted. MPLs may struggle to price risk accurately as:
- MPLs credit risk models are relatively unproven
- many MPLs have not been through the credit cycle, and may perform worse than anticipated once the cycle turns
- MPLs need to scale quickly, which could potentially lead to systematic mispricing of the risk.
Will MPLs in the UK be able to maintain their competitive advantages in the face of these headwinds?
We believe that attracting sufficient funds at a sufficiently low rate for their borrowers may prove to be a significant headwind for MPLs in the UK. Furthermore, this headwind will be exacerbated when interest rates normalise. Deloitte's view is that in the short to medium term, MPLs are likely to have a window of opportunity if interest rates remain "lower for longer" (which, in the UK, seems even more likely to be the case in the wake of the EU referendum), and if banks are unable or unwilling to replicate MPLs' much vaunted customer experience.
However, our findings suggest that MPLs in the UK are unlikely to pose a threat to banks in the mass market in the long term. As such, we do not believe that the banking model in the UK will be fully disrupted by MPLs. We therefore believe that banks can, and should, evaluate a wide range of options for enhancing their overall customer proposition by partnering with MPLs.
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